Monetary Reform with a National Depository

Under the fractional reserve banking system, banks create new deposits through lending without an equal increase in bank reserves being required to back them. That leverage gives large banks enormous financial and political power that has often been misused. Far too much bank lending now goes into purely speculative activities which distort the financial markets, inflate asset prices, increase the fragility of the financial system, encourage financial fraud, and serve no useful purpose in the real economy.

These problems would be much less common with a banking system in which deposits are required to be fully backed by reserves. They would then no longer be able to leverage their bets. We will briefly describe the mechanics of a full reserve banking system. Then we will show how it can be made simpler and more efficient by consolidating the depository role of banks into a single national depository.

Full Reserve Banking

Full reserve banking would force banks to operate as ordinary intermediaries because the reserves that come with new deposits would be fully encumbered. Banks would therefore have limited incentive to seek new depositors. Their value would be mainly as potential lenders to the bank and customers for their loans. They would have to acquire the funds needed for their investments by borrowing, selling assets, using retained earnings, and selling new bankshares.

A bank would need two accounts at the Fed, a reserve account which must be continually matched with the deposits it holds, and an investment account which holds its discretionary funds. When a bank spends, the Fed would debit the bank's investment account and credit the reserve account of the payee’s bank. When a depositor spends, the Fed would debit the reserve account of his bank and credit the reserve account of the payee's bank. In both cases, the payee's bank would credit the payee with a new deposit.

Deposits and reserves in a bank would remain in balance regardless of the financial transactions by its depositors. Therefore the interbank lending market, which serves to rebalance reserves in the fractional reserve system, would not exist in the full reserve system. To control the short-term interest rate, the Fed would have to operate on loanable funds in the money market. It would add or drain funds via open market operations as needed to hold the interest rate on target.

Full reserve banking would be a definite impriovement over the fractional reserve system. However there is a functional equivalent which is simpler and more efficient. It uses a single national depository holding deposits of actual base money rather than private banks holding deposits as proxies for base money called reserves. The remainder of this article describes how such a system would work and how it could be put into operaton.

A Single National Depository System

Suppose the government established a National Depository run by the Fed to take over the depository role of all existing banks. It would hold the transaction accounts of all who need the payment services of a traditional bank. Deposits would earn no interest, and the Depository would neither lend nor borrow. It would simply execute payment orders and exchange cash for deposits on demand.  

One should not confuse the National Depository with a Federal Reserve Bank, which plays a quite different role. However the computer used by the National Depository would be an extension of the Fed's computer system. The accounts at the National Depository together with the circulating cash would comprise the entire money supply denominated in the national currency. The Fed would have control of total deposits but would normally use it to manage the short-term interest rate rather than the money supply itself. 

Payment orders would be accepted by electronic means via plastic cards, the Internet, Fed wire, or telephone. Paper checks would be phased out, after which verifying balances and making payments would all be done in real time. Payments would be executed by simply transferring funds between accounts, except for transactions with the Fed which would involve a transfer of funds in or out of the Depository. Deposit insurance would be eliminated since all deposits would be in custody of the Fed.

Banks would no longer be able to create or accept deposits. They would become ordinary intermediaries whose basic business is borrowing in order to lend at a markup. Those banks that commit to serve as agents of the National Depository and provide payment services for account holders would be newly chartered. All others would lose their charters and no longer be allowed to call themselves banks, but could continue to operate as ordinary intermediaries. To use the payment services of a bank, a customer would have to authorize the bank to debit its account at the Depository for each specific payment. As agents of the National Depository, banks would be allowed to borrow and lend with the Fed. In addition, their customers would be covered by government insurance on loans they made to the bank. 

The National Depository would also serve the U.S. government and a limited set of foreign interests not detailed here. All of the Treasury's funds would be held in its account at the National Depository where it would receive payments on Federal taxes and the sale of its securities. Likewise all of Its public spending would be paid out of its account at the Depository. To avoid impacting the short-term interest rate on loanable funds, the Treasury would have to sell or redeem securities as needed to maintain an approximate balance between its inflows and outflows, just as it does in the current system. That is a necessary condition to enable the Fed to implement monetary policy.

Monetary Policy Implementation

Under normal economic conditions, the Fed implements monetary policy by selecting and controlling the short term interest rate. In the fractional reserve system, the Fed accomplishes that by adding or draining reserves as needed to balance supply and demand at its target interest rate. Since there are no reserves in a single national depository system, the Fed would operate on the money supply itself. That can be done in various ways, but it should be simple and efficient as in the following system:

The Fed would set policy by announcing a target for the annualized interest rate on overnight interbank loans, the Interbank Rate, and adjusting the money supply to balance supply and demand at that rate. It would set an upper bound on the cost to banks of borrowing money by offering them renewable 7-day loans against adequate collateral at an interest rate 50 basis points above the target rate, called the Fed loan rate. It would set a lower bound on the earnings of money held by banks by offering them renewable 7-day interest-earning Fed deposits at 50 basis points below the target rate, called the Fed deposit rate.

When interbank loans trade in the 100 basis point range between the Fed loan rate and the Fed deposit rate, banks would have no incentive to trade outside of the interbank market. However when the demand for money exceeds the supply, the interbank rate could rise to the Fed loan rate, at which point banks would have no incentive to borrow in the interbank market. Conversely if the money supply exceeds the demand, the interbank rate could fall to the Fed deposit rate, at which point banks would have no incentive to lend in the interbank market.

By observing the interbank lending rate and trading volume, the Fed could determine the change in the money supply needed to balance supply and demand at its target rate. It would then buy or sell securities in the open market to increase or decrease the money supply as appropriate. With the Fed acting as needed to control the short-term interest rate, the money supply would grow endogenously, i.e. as a function of the demand for loanable funds, just as it does for credit demand in the fractional reserve system.

Financial Service Companies (FSCs)

Financial service companies engage in a wide variety of activities. They buy and sell financial instruments as diverse as bonds, mortgages, mutual fund shares, and insurance policies. Like everyone else, their money would be held in accounts at the National Depository. Since money earns no interest, FSCs would normally hold only as much as they need for near-term investments and payment obligations. Most of their liquid assets would be in interest-earning short-term investments like repos or Treasury bills and money market funds which could be quickly sold for cash as needed. Firms and individuals seeking a return on their liquid assets have a variety of options. For example they could purchase Treasury bills, money market funds, or make short term loans to banks or other FSCs. 

As government-chartered FSCs, banks would be restricted in their financial instruments and held to tight capital adequacy requirements. They would borrow from the Fed mainly for liquidity management rather than as a source of funds to lend. Their primary source of funds for investment would be through loans from savers/investors, for which they would pay market rates. Ensuring the loans by a government agency should provide incentives for savers to lend to banks in preference to other FSCs, and thereby enhance capital formation. Note that insurance on loans to banks plays a role similar to deposit insurance in the fractional reserve banking system.

FSCs differ widely in the degree to which they mismatch the maturity of their assets versus liabilities. Mismatching creates a potential cash flow problem. The main concern is a systemic failure in which default by a major FSC could bring down many others due to the cascading of liabilities among them.  A single national depository system would not automatically end excessive risk-taking. Therefore capital adequacy requirements should be imposed on all FSCs. For those designated as "too large to fail" because of the chaos a failure might create, the required ratio of capital to risk-adjusted assets should be an increasing function of the mismatch in their maturities.

Government insurance should not be provided on financial instruments other than loans to banks. Bond rating firms should rate the credit worthiness of FSCs as institutions, which would be of value to investors. Perhaps more importantly,  FSCs would tend to avoid practices that reflect badly on their assets.

Implementing the System

Implementing a single national depository system could not be done overnight.  It would have to be carefully planned and phased in slowly enough to give all parties adequate time to make the necessary adjustments. A logical way to proceed would be to periodically increase the reserve ratio requirement on banks until it reached 100 percent. During that period, banks would have to pay off and close out their interest-earning deposits. To acquire the funds, they would probably need to call loans and downsize their balance sheets.  The Fed would also have to adjust reserves as needed.

When the reserve ratio requirement reached 100 percent, all bank deposit liabilities should have been paid off, leaving only demand deposits fully backed by reserves. The transition from a multi-bank fractional reserve system to a single national depository system would be complete when the demand deposits and their reserves were transferred to the National Depository.

Since money in the National Depository earns no interest, the total would be considerably less than total deposits in banks in the fractional reserve system. As a rough estimate, the National Depository would initially hold an amount equal to then current checkable deposits in banks, plus some fraction of savings deposits, plus eurodollar deposits.

Advantages of a Single National Depository System

The financial system would be more robust. When a bank must spend cash to issue a loan, it would tend be more diligent in credit analysis. Lending to highly leveraged borrowers would be reduced, decreasing the likelihood of asset price bubbles and subsequent crashes.

The political and economic power of large FSCs would be reduced, which would reduce the cost of financial services to the overall economy and the share of profits going to the financial sector.

The payment system would be much simpler. With all deposits and transactions running on a single computer system, sufficient funds could be verified in real time and payments executed without delay, thus eliminating checking system float with its associated costs.